2 Investing Initiative response to the European Commission consultation on the long- term financing of the European economy

Transcription

1 2 Investing Initiative response to the European Commission consultation on the long- term financing of the European economy 24 June

2 ABOUT US The 2 Investing Initiative [2 ii] is a multi- stakeholder think tank bringing together financial institutions, issuers, policy makers, research institutes, experts and NGOs. The 2 Investing Initiative proposes to create a framework that connects the dots between climate goals, portfolio allocation and financial regulation, by building a set of new approaches, integrating climate change issues into mainstream finance. The 2 Investing Initiative programme is organized via four workflows: Research: 3- year R&D programme, aiming to create a climate performance indicator. Reports: quarterly based publication of in- depth reports, covering a multiplicity of issues that can contribute to integrate climate change constraints in Finance. Conferences and workshops: organization of events in the frame of our own work; participation in invited talks, debates and keynotes. Consultations: participation in consultations organized by different types of stakeholders (e.g. governmental bodies, European Parliament, NGOs) 2 Investing Initiative was registered on 25 October 2012 as an Association under the law Investing Initiative authorizes the publication of this consultation response or parts thereof should the Commission decide to do so. For further information, please contact Stanislas Dupré, Director at 2 Investing Initiative: Cell: Landline: degrees- investing.org 47 rue de la Victoire, Paris This document provides an summary of our analysis and recommendations. The detailed version of these answers is available in four annex documents which can be downloaded: ANNEX 1 - FROM FINANCED EMISSIONS TO LONG- TERM INVESTING METRICS (Draft report 98 pages), 2 Investing initiative in partnership with ADEME, AFD, CDC, UNEP- FI and ABC (2013) ANNEX 2 - CONNECTING THE DOTS BETWEEN CLIMATE GOALS, ASSET ALLOCATION AND FINANCIAL REGULATION (30 pages report), 2 Investing initiative (2012) ANNEX 3 - INTÉGRATION DU RISQUE CLIMATIQUE DANS LES MODÈLES PRUDENTIELS (concept note), 2 Investing initiative (2012) ANNEX 4 - MODULER LA FISCALITE DES SUPPORTS D EPARGNE EN FONCTION DE LEUR CONTRIBUTION AU FINANCEMENT DES BESOINS DE LONG TERME ET DE LA TRANSITION ENERGETIQUE (position paper), 2 Investing initiative (2012) ANNEX 5 - CRITICAL FRIENDS, THE EMERGING ROLE OF STAKEHOLDER PANELS IN CORPORATE GOVERNANCE, REPORTING AND ASSURANCE, AccountAbility/Utopies (2007) 2

3 1. Do you agree with the analysis out above regarding the supply and characteristics of long- term financing We almost agree with the analysis regarding the supply and characteristics of long term Financing, but three aspects of the analysis seem under- developed according to our view : - - Geography : The paper relates to The capacity of the economy to provide the financing for long- term investment depends on its ability to generate savings and attract and retain foreign direct investments (FDI). This minimizes one aspect: the capacity to transform savings into local/regional investments rather than foreign investments. Even if the related goal might raise various concerns such as the lack of geographical diversification for investors and the breach of free- market rules for policy- makers, it seems to be pursuit by Member States (e.g. underlying objectives of tax incentives on savings). In this respect, it is important to distinguish listed large cap equity holdings (channeling capitals to fuel mostly or partly foreign investments) and private equity holdings (benefiting mostly to the national economies) Industries and climate- related technologies. While the introduction and the staff working paper both mention the transition to a low- carbon economy as a key challenge, long- term financing seem only analyzed under the angle illiquid/versus liquid assets. Our analysis shows that the current misallocation of capitals by financial intermediaries is also a question of industry & technology allocation 1. From an investor s perspective, the transition to a low- carbon economy is fundamentally a reallocation of investments in a process of creative destruction (form fossil- based industries & technologies to low- carbon industries & technologies) rather than the provision of additional financing for the green assets. Cf. Annex 1 page Anticipation of point- in- time risks. Long- term investment horizons do not necessarily lead to the anticipation of long- term risks, due to principal- agent concerns and the lack of relevant risk- assessment frameworks. In our views, long- term investing is not only the capacity of asset- owners and intermediaries to provide capital to form long- lived tangible and intangible capital, but also to anticipate point- in- time- risks 2 : a risk that is highly predictable, very likely to occur at one point in time, can cause the owner to go bankrupt, can sometimes have systemic effects, but is not material in the short term. Report to Annex 1 page 8 to Do you have a view on the most appropriate definition of long- term financing? OUR ANALYSIS : We consider that, at macro- economic level, long- term financing is an allocation of assets which fulfills the following objectives: Fulfill the investment needs of the real economy, in line with economic policy- goals (notably the transition to a low- carbon economy), 1 IEA s World Energy Outlook and, Energy Technology Perspectives 2 Measurement, governance and long-term investing, WEF(2011). 3

4 Prevent the formation of financial bubbles and anticipate other point- in- time risks. As a consequence a long- term investor should be defined based on the following criteria: An investor with long- term liabilities that has an actual investment horizon matching its liability constraints (including constraints related to capital requirements), An investor who tracks and optimize its contribution to financing the long- term desired investments in sensitive industries and technologies (for foreseeable economic transitions) An investor who tracks and manage its exposure to point- in- time risks. Besides, an alignment with climate goals is required. We coined the related concept of 2 investing: investment strategy consistent with +2 C investment roadmaps. We are currently (2-3 years project) developing a model and benchmarks to assess investment portfolios and financial institutions. This model will more broadly inform investors on the alignment of their asset allocation strategy with long- term investment needs. Report to Annexe 1 page 85 OUR RECOMMANDATIONS We consider that any policy incentivizing long- term investment should take into account the actual impact of the investors on the economy and not only the structure of their liabilities. We encourage the EU to support the development of long- term investing metrics and the related assessment frameworks (e.g. the 2 Investing Metric program) 3. Given the evolving nature of the banking sector, going forward, what role do you see for banks in the channeling of financing to long- term investments? OUR ANALYSIS : Beyond their role in lending, commercial banks play a key role in the allocation of household savings, as retailers of investment products. Despite the progress made in informing individual investors in the wave of MiFID, many commercial banks in many member countries are still very far to play a client- oriented role in channeling private savings: Principal- agent concerns (e.g. commercial objectives, remuneration schemes and inducements involve almost systematically significant conflict of interests) prevent the pursuit of long- term risk- adjusted returns to prioritize short- term performance against benchmarks 3 ; The metrics used to communicate on risk and performance (e.g. evolution of value against a benchmark over 1- year) are usually inconsistent with the investors horizons, and entirely based on a rear mirror view (e.g. the risks identified by companies and equity analysts, especially long- term ones are not reflected in the risk score communicated to final investors. The only criteria is volatility) 4. Mass retailing of standardized products (versus advice on an individual investment strategy) dramatically limit the diversity of investment strategies and shorten artificially the investment horizons of fund managers (high turnover rates, investment horizons shorter than what is communicated to clients 5 ). 3 The future of long-term Investing, WEF (2011) 4 Measurement, governance and long-term investing, WEF(2011). 5 Investment horizons. Do managers do what they Say? Mercer

5 In this context, many macro- economists blame private investors erratic and sheep- like behavior, but an empirical analysis of retailing channels clearly shows that short- termism is deeply rooted in most commercial bank marketing practices. OUR RECOMMANDATIONS This issue clearly requires policy interventions: Regulation of remuneration schemes and inducement to avoid fundamental misalignment of sales team objectives with clients long- term interests; Banning the use of short- term metrics in the promotion of long- term investment products (cf. Finance Watch s position paper on PRIPS). Mandatory disclosure of the actual investment horizon of the investment products (i.e. based on the turnover for equity funds), the discrepancy with clients objectives and the consequences in term of fees and potential returns. The related proposals are described in the annex #2, pages How could the role of national and multilateral development banks best support the financing of long- term investment? Is there scope for greater coordination between these banks in the pursuit of EU policy goals? How could financial instruments under the EU budget better support the financing of long- term investment in sustainable growth? OUR ANALYSIS: While most public banks are supposed to finance the long- term needs of the economy, and in many case the transition to a low- carbon economy (in line with a +2 C target), no one assess systematically and quantitatively the alignment of its asset allocation strategy with these goals. This lack of performance measurement against public policy objectives has two major consequences: Misalignment. Many public and development banks might finance projects that are incompatible with public climate goals (i.e. with investment roadmaps leading to 2 C pathways). Environmental NGOs spotlight controversial projects frequently. Many banks respond by strengthening their sector policies, but no framework exists to act proactively and make sure that the banks actually play a role compatible with their mandate. Beyond project screening, there is usually no metric to inform asset allocation by macro- sector, industry or climate- related technology. Bottom- up prioritization. Regarding green projects and innovation at the upstream stage of the innovation curve, public banks apply investment programs driven by specific policy objectives (e.g. a plan to develop high speed rail). Projects that do not fall in this category are usually analyzed with a bottom- up approach regardless of the long- term investment needs in certain technologies or industries identified in low- carbon investment roadmaps (e.g. the IEA energy technology perspectives scenario). As a consequence, public banks tend to finance projects that already attract the private sector (this criteria being in many cases used formally or informally to green projects). This is especially true at the first stages of the innovation process (R&D, venture capital and private equity), for which the interest from major industrial players is in many cases the main way for public banks to assess the credibility of the project. Therefore, when they are not constrained by a specific investment program, due to the lack of performance metric, Public banks usually do not take into consideration the investment needs in certain immature technologies even if they are crucial to unlock large- scale decarbonization over the long term (e.g. batteries for electric cars in early 2000s, breakthrough low- carbon technologies in industries like cement or steel now). 5

6 OUR RECOMMANDATION: We consider that the EU can play a key role in supporting the development of such performance metric and recommending public and development bank to use them and report their performance publicly. Cf. page 90, Annex 1, and page 21 Annex 2 Some development banks have already started to do this (Cf. annexe 1), but it is limited to the impact of clean energy and energy efficiency projects and therefore covers a very small part of the financing they provide to the economy. 5. Are there other public policy tools and frameworks that can support the financing of long- term investment? 6. To what extent and how can institutional investors play a greater role in the changing landscape of long- term financing? OUR ANALYSIS: According to the definition we provide in Question #2, very few pension funds and insurers fall into the category of long- term investors today, given the fact that they do not meet any of the three criteria: their actual investment horizons do not match their liability structure (being much shorter), they neither track the alignment of their investment with long- term investment needs, nor their exposure to point- in- time risks. Studies show that this situation is not the result of prudential rules, but mostly due to the combination of disfunctionning governance frameworks and investment processes, and inappropriate performance metrics. The consequence is negative both from final investors (lower risk- adjusted returns, more transaction costs) and the economy (misallocation of capital, more systemic risks). OUR RECOMMANDATIONS: We consider that addressing that this issue on artificial short- termism should be a priority for policy- makers. The creation of new vehicles (e.g. long- term investment funds, securitization, etc.) to turn long- term investments into tradable assets should be promoted but should not be considered as an option to avoid addressing artificial shortermism. 7. How can prudential objectives and the desire to support long- term financing best be balanced in the design and implementation of the respective prudential rules for insurers, reinsurers and pension funds, such as IORPs? 6

7 OUR ANALYSIS: Our analysis shows that there are two ways to rebalance the impact of prudential rules: The first one would be to align the time horizons of risk assessment frameworks with the investment horizons of FIs. This can be achieved by the introduction of stress- tests related to major cross- asset long- term/ point in- time- risks (e.g. climate risks) The second way would be to use the framework set by prudential regulation (accounting + assessment + reporting + incentives) as a public policy- tool available to achieve economic objectives (rather than only short- term systemic risk management). In this case, the capital requirements would be adjusted to be based on performance metrics (alignment of their investment with long- term investment needs) whatever the correlation with direct credit or market risk exposure for the financial institution. OUR RECOMMANDATIONS > These proposals are developed in the annex 2 (page 19) and 3 (full paper Fr), with a focus on climate risks, but the related policy tools can be relevant whatever the underlying long- term economic goals. 1. What are the barriers to creating pooled investment vehicles? Could platforms be developed at the EU level? 2. What other options and instruments could be considered to enhance the capacity of banks and institutional investors to channel long- term finance? 10) Are there any cumulative impacts of current and planned prudential reforms on the level and cyclicality of aggregate long- term investment and how significant are they? How could any impact be best addressed? 11) How could capital market financing of long- term investment be improved in Europe? Refer to recommendations made on questions 2,3,6,17 12) How can capital markets help fill the equity gap in Europe? What should change in the way market- based intermediation operates to ensure that the financing can better flow to long- term investments, better support the financing of long- term investment in economically-, socially- and environmentally- sustainable growth and ensuring adequate protection for investors and consumers? 13) What are the pros and cons of developing a more harmonized framework for covered bonds? What elements could compose this framework? 7

8 14) How could the securitization market in the EU be revived in order to achieve the right balance between financial stability and the need to improve maturity transformation by the financial system? 15) What are the merits of the various models for a specific savings account available within the EU level? Could an EU model be designed? 16) What type of CIT reforms could improve investment conditions by removing distortions between debt and equity? 17) What considerations should be taken into account for setting the right incentives at national level for long- term saving? In particular, how should tax incentives be used to encourage long- term saving in a balanced way? OUR ANALYSIS In most countries, tax incentives on savings interests are the main policy tool to channel these private savings and influence asset managers allocation strategies. From a public accounting perspective, these incentives are considered as subsidies to foster savings and investments in the real economy. Their cost is significant: they represent tens of billions of euros in countries like France or the UK. These tax schemes are designed at country level and reviewed on a yearly basis. Incentives related to the financing of the economy (e.g. bonus for long term savings and investment in equities) are in most cases indirectly linked with specific investment vehicles (e.g. tax- free accounts, UCITS, etc.). OUR RECOMMANDATIONS In this context, the 2 Investing Initiative recommends that policy- makers: Assess, in each country, the impact of tax incentives on long- term finance and the energy transition, using the best- available techniques Study the alignment of these incentives with the investment roadmaps of 2 scenarios. A mechanism for this would for instance include the modulation of the tax scale applied to all savings products (fund, account, life- insurance contract, etc.) based on the contribution of the underlying asset portfolio to the financing of the energy transition (cf. metrics page ). This scheme would first act as a carbon tax on investments, resulting in lower capital costs for green investments (green bonds, funds, loans, clean techs companies, etc.) and higher capital costs for industries and projects not aligned with the goals of the energy transition such as coal mining or the construction of coal- fired plants. It would therefore encourage investors to design green investment vehicles and companies to raise capital for green capital expenditures and R&D projects. The second effect would be to increase the flows of investments in the real economy (vs. purely speculative activities). Cf. Annex 4 (Fr) 8

9 18) Which types of corporate tax incentives are beneficial? What measures could be used to deal with the risks of arbitrage when exemptions/incentives are granted for specific activities? 19) Would deeper tax coordination in the EU support the financing of long- term investment? 20) To what extent do you consider that the use of fair value accounting principles has led to short- termism in investor behaviour? What alternatives or other ways to compensate for such effects could be suggested? 21) What kind of incentives could help promote better long- term shareholder engagement? We recommend introducing mandatory stress- tests on point- in- time risks (e.g. climate change related risks) for both investors and equity issuers. Cf. recommendations for question 7 Such a requirement will necessarily raise the level of interest of investors on long- term performance. Additionally, the analysis of point- in- time risk by issuers can be supervised by independent committees including stakeholders as recommended in the annex 5. Refer to. Annexe 5 page ) How can the mandates and incentives given to asset managers be developed to support long- term investment strategies and relationships? Two different problems need to be addressed: Asset- owners should be incentivized to set mandates aligned with their investment horizon (duration, performance metrics, incentives). Asset managers should track and manage their performance against the client s objectives and horizon, instead of using short term metrics. We consider that these objectives can be achieved with a mix of: New regulations regarding remuneration schemes for asset managers and the use of performance metrics è Cf. recommendations 2 and 3 Mandatory disclosure about the actual investment horizon and allocation of portfolios (traceability) across the investment chain. Refer to Annexe 2 9

10 23) Is there a need to revisit the definition of fiduciary duty in the context of long- term financing? As described in question #3, the investment horizon of most asset managers is misaligned with their clients horizon and many investment products are still sold based on irrelevant or even misleading performance metrics. The fiduciary duty of asset managers should be revisited to make sure that: Their actual investment horizon (e.g. turnover for equity portfolios) match the client s horizon ; The turnover of portfolios is optimized in the best interest of clients, taking into account the level of fees related to transactions. 24) To what extent can increased integration of financial and non- financial information help provide a clearer overview of a company s long- term performance, and contribute to better investment decision- making? 10

11 OUR ANALYSIS 6 It is important to distinguish three types of non- financial information: analysis of long- term risks, information of long- term investments and CSR reporting. Analysis of long- term risks. Most regulatory frameworks (e.g. capital requirements calculation rules, financial reporting requirements for companies) narrowly define financial risks excluding implicitly point- in- time risks. As far as reporting requirements for listed companies are concerned long- term risks are not formally excluded but the lack of precise guidelines in this area by market authorities, and loose law enforcement on this topic (cf. ) create disincentive to report: given the lack of clear framework, external auditors have no mandate to challenge companies reporting on this topic; given the lack of reporting, risk departments and sustainability department are in most cases advised by legal departments not to explore the financial materiality of long- term risks, because o o it is not considered as relevant, it might expose the company to shareholder litigation if a non- reported risk eventually materialize. As a consequence most listed company do not discuss nor assess point- in- time risks in the risk factors section of their annual accounts, even when they are easy to identify and quantify (e.g. stress test on changes in public policies in industries highly exposed to controversial or high external cost practices such as tobacco, nuclear power, etc.). OUR RECOMMANDATIONS We recommend the Commission to explore this issue and strengthen reporting requirements on risk factors, including: Developing a comprehensive mapping of point- in- time risks industry- by- industry in collaboration with companies, investors and stakeholders; Requiring the publication of stress- tests for key point- in- time risks in sensitive industries (notably on climate risks). Mandatory disclosure regarding point- in- time risks can also pave the way for the evolution of accounting standards, especially regarding rules for calculating impairments. 25) Is there a need to develop specific long- term benchmarks? OUR ANALYSIS Equity investments are assumed to play a key role in financing the global economy. In practice, for governance and marketing reasons, the allocation of most portfolios is driven by the sector allocation of benchmark indices (Dow Jones, FTSE, MSCI, etc.). This practice implies very strong biases in terms of geographic and sectorial footprint, and contributes to the shortening of 6 About 24 and 25 our analysis and recommandations are in line with WWF position. 11

12 investment horizons since fund managers are incentivized on their ability to beat the benchmark on a monthly basis rather than on the long term performance of their fund. Consequently, the investment is almost disconnected from final investors returns over their investment horizons. The sector allocation of standard stock indices does not reflect the sector exposure of the real economy ( Cf. chart below): notably mining and power production are over- represented. The main criteria for the selection of components are capitalization and free- float. That leads to an over- weighting of established players and the exclusion of new comers from the investment universe. The consequence is a high exposure to fossil industries (10-15%) and a very low exposure to clean technologies (<2%) compared to both investment targets of climate scenarios and the trends of the real economy. The picture seems to be similar for corporate bonds indices, however, this topic is less documented and the use of benchmarks seems to have fewer impacts on investment strategies compared to stock- indices. OUR RECOMMANDATIONS Introducing new metrics. We recommend the EU to support the development of long- term investing metrics and benchmarks such as the 2 Investing Metric project presented in annex 1. However the existence of alternative long- term benchmark will not have any impact on investment behaviors if no incentive to adopt them is introduced. The case of Socially Responsible Indices (e.g. FTSE 4 Good, DJ Sustainability Index) introduced in the early 2000ies with almost no uptake by investors supports this analysis. Disclosure of alignment. In the short term we recommend that policy- makers require stock- indices and bond- indices providers to assess and disclose the gap between the index allocation and the allocation aligned with long- term investment needs over the next years. The information document would require a specific focus on 2 investment roadmaps based on qualitative analysis in the short- term and quantitative data when the 2 investing metrics will be available (Cf. annexe 1). Our forthcoming study on benchmarks will provide an example of such an analysis. Introduction of incentives. This reporting will allow market authorities to evaluate if financial markets contribute toward financing the real economy and do not fuel new financial bubbles. They can then introduce regulations or incentives on the use of benchmarks if the results are interpreted as a threat to economic growth and financial stability. 12

13 Source: Beyond Financials for 2 Investing Initiative. Forthcoming 2 ii study on the use of benchmark and long- term financing This chart compares gross fixed capital formation of listed companies (Reuters data) and national economies (World Input Output database). Listed companies investment data are classified with the NAICS 2002 taxonomy Countries data are classified by sectors, in ISIC rev 3.1 taxonomy level 1 and 2. For the purpose of this analysis, NAICS 2002 sectors are converted into ISIC rev 3.1 ones. Some NAICS 2002 categories fall into several ISIC rev3.1 categories. To reduce double counting we converted data from ISIC rev 3.1 level 1 to ISIC rev 3.1 level 2. The chart shows the upper and lower estimates for listed companies based on different assignments. 13

14 26) What further steps could be envisaged, in terms of EU regulation or other reforms, to facilitate SME access to alternative sources of finance? 27) How could securitisation instruments for SMEs be designed? What are the best ways to use securitisation in order to mobilise financial intermediaries' capital for additional lending/investments to SMEs? 28) Would there be merit in creating a fully separate and distinct approach for SME markets? How and by whom could a market be developed for SMEs, including for securitised products specifically designed for SMEs financing needs? 29) Would an EU regulatory framework help or hinder the development of this alternative non- bank sources of finance for SMEs? What reforms could help support their continued growth? 30) In addition to the analysis and potential measures set out in this Green Paper, what else could contribute to the long- term financing of the European economy? 14